United States: Do the SEC’s Proposed Standards of Professional Conduct for Attorneys Apply to You?

Co-authored by David Smith

When The Security and Exchange Commission "SEC" or Department of Labor ("DOL") or FBI Special Agent investigator knocks on defense counsel’s office door to conduct an interview relating to a client’s alleged violation of the Sarbanes-Oxley Act ("the Act"), she might recall skimming an article and concluding that it did not apply to her role as defense counsel in product liability cases. She should think again. In light of the recent financial debacles, including Enron and World Com, the SEC is fulfilling the Congressional mandate to require public companies to disclose and remediate material violations, breaches of fiduciary duties and similar violations of the SEC regulations. This article will discuss the SEC’s definition of an "attorney" under 17 CFR Part 205 and it’s newly proposed alternative to an earlier draft "noisy withdrawal" ethics rule, attorney withdrawal and disaffirmance with client notification to the SEC of withdrawal. The following scenarios demonstrate when and how an attorney may have to respond under the Act. Scenario No. 1 You are national coordinating counsel for a publicly owned manufacturer. During the decade that you have represented the company in multidistrict litigation, your client has been a beneficiary of several favorable judicial rulings from state and federal courts where most of the allegedly defective products were distributed. However, tort reform favoring plaintiffs has been adopted in the two states where most of the lawsuits are filed. The reform includes two changes that will greatly impact the defense of the product claims. First, the statute of limitations has been extended by a new discovery rule which increases the time for filing suit from three years to eight years. Second, the cap on noneconomic damages is eliminated. These changes dramatically increase the number of suits anticipated by the company since the product was removed from distribution four years ago. The values of prior settlements and verdicts used for case evaluations are now meaningless as the "sky is the limit."

After conducting your analysis on the effects of the tort reform, you provide written notice to both in-house counsel managing the claims and the insurer. The insurer advises that in light of the tort reform, there will likely not be enough insurance to defend all of the prospective suits. You also complete an audit request from the company’s outside auditor and report the anticipated increased volume and value of suits. You further report that the amount of insurance coverage may be insufficient to cover the anticipated losses. In-house counsel downplays the reforms and expresses his opinion that there aren’t likely to be very many new lawsuits as a large number were filed prior to the expiration of the original statute of limitations.

At years end, you receive a copy of the company’s financial report and notice that the section on current and future litigation is silent about the recent tort reform and potential impact on the company’s financial status.

Scenario No. 2 In a product liability case involving a punitive damages claim, you are preparing a vice president from the accounting department to respond to a CR 30(b)(6) deposition regarding the company’s finances. As you begin reviewing the financial statements with the VP, he states that he wants to divulge something that has been troubling him for a long time. For five years, he has disagreed with the manner in which the profits have been calculated. Each year he has reported his concerns about his perceived misrepresentations to the Chief Financial Officer, who has brushed his comments aside and warned him that his job duties do not include determining how the Board of Directors and auditors characterize the company’s profits. Realizing he will be placed under oath, the VP maintains that he will testify that the corporate profits have been mischaracterized resulting in inflated profitability in both financial statements and other documents given to the SEC, investors, creditors and employees.

These scenarios may create an "up the ladder" reporting duty for the product liability attorney under the Act, and possibly result in defense counsel’s withdrawal and disaffirmance of any final reports relying upon counsel’s status reports for "professional considerations." Failing to comply with those requirements may subject the attorney to the discipline contained in the Sarbanes Oxley Act.

On January 23, 2003 the SEC adopted final rules under Section 307 of the Sarbanes Oxley Act which set standards for attorney conduct . This analysis is premised on the SEC’s "Implementation of Standards of Professional Conduct for Attorneys; Final Rule and Proposed Rule," 17 CFR 205, 240, and 249, published February 6, 2003 (available at www.sec.gov/rules/proposed/33-8186.htm). (See Online column, infra. p. 6 )

Defense counsel must initially consult with her firm’s ethics or corporate compliance committee to review the facts and all firm policies and/or guidelines from insurers to determine, which response, if any, is needed. If the attorney/firm does not have an in-house ethics/compliance expert or committee with whom to consult, consideration should be given to retaining outside counsel versed in the Act’s requirements. The first step is to determine whether defense counsel is an "attorney" covered by the Act as defined in section 205.2(a).

The proposed definition of an "attorney" is set forth in section 205.2(a):

(a) Appearing and practicing before the Commission includes, but is not limited to, an attorney’s:

(1) Transacting any business with the Commission, including communication with Commissioners, the Commission, or its staff;

(2) Representing any party to, or the subject of, or a witness in a Commission administrative proceeding;

(3) Representing any person in connection with any Commission investigation, inquiry, information request, or subpoena;

(4) Preparing, or participating in the process of preparing, any statement, opinion, or other writing which the attorney has reason to believe will be filed with or incorporated into any registration statement, notification, application, report, communication or other document filed with or submitted to the Commissioners, the Commission, or its staff; or

(5) Advising any party that:

(i) A statement, opinion, or other writing need not or should not be filed with or incorporated into any registration statement, notification, application, report, communication or other document filed with or submitted to the Commissioners, the Commission, or its staff; or

(ii) The party is not obligated to submit or file a registration statement, notification, application, report, communication or other document with the Commission or its staff.

Under section 205.2(a) as currently drafted, defense counsel likely would be considered an "attorney" for purposes of "up the ladder" reporting.

Defense counsel in Scenario No. 1 responded to an audit request knowing that the information would be used by the auditors to evaluate the financial status of the company and prepare documents to be submitted to the SEC and investors. When defense counsel reported the likely impact of the tort reform to in-house counsel and the auditors, she was aware that the information about current and prospective costs of litigation, including defense costs, future settlements and potential adverse verdicts would be included in a financial analysis. Since defense counsel reasonably advised the manufacturer that the pro-plaintiff tort reform would impact the company’s "bottom line," the attorney likely comes under the Act’s provisions.

In the second scenario, defense counsel comes within the definition of "attorney" once she is advised of a misrepresentation of the company’s profits. The mischaracterization of profits submitted in documents prepared for and submitted to the SEC and/or investors would constitute a "material" violation under Sections 205.2 (e) and (h) as currently proposed.

"Evidence of a material violation means information that would lead an attorney reasonably to believe that a material violation has occurred, is occurring or is about to occur." and "Material" refers to conduct or information about which a reasonable investor would want to be informed before making an investment decision."

A prudent investor highly values the profitability of a company and includes that factor in the decision-making to buy, sell or trade.

The existence of any attorney-client privilege must be assessed, being mindful that the "control group" of the corporation (in most circumstances, the Board of Directors) is the client. The attorney representing the "issuer" corporation does not represent its officers and employees simply because "the attorney necessarily interacts with them in representing the issuer and the attorney should make that clear to those officers and employees. Any attorney-client privilege for information related to the issuer’s affairs that the officers and employees communicate to the attorney belongs to the issuer." Comments to Proposed Standard. In Scenario No. 1, in-house counsel may or may not be "the client" and any information received from in-house counsel and conveyed "up the ladder" is considered privileged as it relates to the issuer. In scenario No. 2, the VP would not be "the client," thus any attorney-client privilege applicable to the statements made by the VP belongs to the issuer. In defending itself in any future litigation, the issuer may chose to waive the attorney-client privilege and disclose what the VP told defense counsel (and what defense counsel told or failed to tell the Board) as a fact in mitigation of penalties in any subsequent SEC investigation or proceeding.

What must defense counsel do to comply with the Act upon learning that the annual report and/or financial statements lack any disclosure of the tort reform and likely adverse impact on company profit and or the misrepresentation of company profits? The Act was designed to encourage/mandate "up the ladder" reporting of material violations. Section 307 of the Act requires the commission to establish a rule

"(1) requiring an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the company or any agent thereof, to the chief legal counsel or the chief executive officer of the company (or the equivalent thereof); and

(2) if the counsel or officer does not appropriately respond to the evidence (adopting, as necessary, appropriate remedial measures or sanctions with respect to the violation), requiring the attorney to report the evidence to the audit committee of the board of directors of the issuer or to another committee of the board of directors comprised solely of directors not employed directly or indirectly by the issuer, or to the board of directors."

In both scenarios, counsel would have a duty under Section 205.3(b) (1) to give initial notice of the material violations and breach of fiduciary duty to the chief legal counsel "CLC" or the chief executive officer ("CEO") of the company. If the CLC and/or CEO don’t provide an appropriate response i n a reasonable time reflecting both the completion of an investigation and implementation of remedial measures, if warranted, the attorney must report to the audit committee, another committee of independent directors, or the board of directors. The attorney also has the option to disclose the information to the qualified legal compliance committee ("QLCC") and once reported, has no continuing obligations. Defense counsel must maintain documentation of these actions.

If defense counsel’s reports to the CLC, CEO, audit committee or Board do not generate an appropriate response or an appropriate response in a reasonable time and the attorney believes a material violation is ongoing, about to occur and is likely to result in substantial injury to the financial interest or property of the issuer or investor, the SEC’s proposed withdrawal rule would require the attorney to disaffirm any financial reports she contributes to and then for the company to advise the SEC of the withdrawal.

The fast paced, high stress arena of product liability defense just became more complicated. Careful attention must be paid to the use of information submitted in audit responses. Additional reporting requirements for attorneys give a whole new meaning to "being the bearer of bad news."

Kim Baker is a nurse lawyer who is a member of the Seattle law firm of Williams, Kastner and Gibbs. She is a member of and frequent speaker at the Defense Research Institute and Federation of Defense and Corporate Counsel meetings on products liability, healthcare and employment.

David Smith is a former prosecutor and now member of the Seattle office of Williams, Kastner and Gibbs. His practice emphasizes white collar crime investigations and related criminal, civil and administrative litigation. He is the Chair of the Defense Research Institute White Collar Crime committee.